Alphabet (Google) – Investment Thesis (6 Nov 2019)

“In investing, what is comfortable is rarely profitable.”

Robert Arnott.

Alphabet's business consists ~85% comfort and ~15% innovation. At the current valuation, this may seem an uncomfortable proposition for a value focused investor, but the ~15% has the potential to more than quadruple over the next 10 years. Management has shown the Alphabet innovation pipeline works, and whilst uncomfortable to invest based on uncertainty, in my view Alphabet represents an attractive investment proposition underwritten by the ‘~85%’ representing the cash generating advertisement business.

What does the company do?

Alphabet (‘GOOGL’), founded in 1998, operates in the internet and new media sector, and most notably owns Google. Google itself owns in excess of seven Properties with over 1 billion users including Search, YouTube, Cloud, Android, Hardware, Infrastructure and ‘Other Bets’. On any given day over 1 billion people use a GOOGL product. GOOGL generated US$137bn gross sales (organic growth ~23% y/y), US$42bn EBITDA (30% margin) in 2018 and, unlike many other technology businesses today, is profitable with c.US$30bn net profit (27% margin). Over 71% of sales are generated by advertisements across Google’s owned properties and 13% by advertisements across its partner network (3rd party owned sites). The remaining 16% of sales is generated from Cloud operations, Android mobile operating system, other hardware sales, and Other Bets (Verily, Weymo, moonshots etc.).

How does GOOGL compete across businesses?

GOOGL is the #1 provider globally in online search within the US$1T advertisement sector, a leading position attained through its superior search algorithm which continues to be an unchallenged and powerful moat that has defined its brand, with adoption of the word “Google” in the English language to refer to search. Google’s brand is ranked #2 most valuable brand by Interbrands with estimated value c.$168bn (equivalent to c.20% of equity value). Search advertisements (c.85% 2018A sales) is the main business and cash flow generator. Through heavy capex investments, innovation and acquisitions, the company has applied its search competency to online media (YouTube), and its technology innovation competence to Cloud, Hardware, Mobile and other high potential areas by developing business lines such as AI (Deepmind), healthcare (Verily), autonomous vehicles (Weymo), smart home (Nest) and others. This combination of core advertisement business, emerging cloud/AI/networking business and long-shot innovation pipeline includes untapped synergies across the portfolio (numerous examples include: AI, cybersecurity, neural networking and cloud), as well as other potentially high value impact but lower probability options.

GOOGL is dependent on continued dominance of the search marketplace to generate advertisement sales, in which the top two global players (GOOGL and Facebook) capture over 50% market share. As search usage and advertisement dollars shift from offline (TV, print) to online, the two firms have captured c.77% of the new spending growth. With GOOGL accounting for c.10% of global ad spend, there is certainly significant runway in this large and growing US$1T market. This structural trend is expected to continue to support GOOGL organic sales growth, which has averaged c.20-27% over the last 10 years. History has not witnessed a business of this size growing at such a rapid rate and never has an advertising platform dominated the world like Alphabet. The natural question to ask is can growth continue? Google’s core search business maintains its moat through scale and continual innovation to avoid disruption. Search is a fundamental online requirement, and it is likely competitors are innovating for disruption, however to date there are limited direct competitors of scale (including those with large R&D programs such as Microsoft’s Bing and China-based Baidu). Google’s search business is heavily weighted to US and Europe, limiting exposure to the current US-China political tensions; however, a potential partnership with Baidu or China entry strategy would potentially more than double the current valuation – although this truly is a blue sky scenario and would require both a politically supported opening up of China’s technology sector and a technology transfer agreement permissible by Google management. Given the current poor level of search usability in China, I believe there is scope for such an outcome, although likely a piecemeal implementation over several years.

YouTube is an emerging business for GOOGL in the nascent stage of monetization. With 1.5 billion users and 4 billion videos served daily, it is deeply entrenched in consumers’ psyche. Interestingly, YouTube is only beginning to contribute to Alphabet’s profitability. As the ‘rivers of gold’ are diverted from traditional media, YouTube’s hidden value will begin to emerge. In addition, comparing China’s leading video platforms iQiyi, BilliBilli, Douyin and Alibaba’s Taobao video integration, there is a huge potential to monetize YouTube not only through advertisements, but also through online shopping adaptations (which has not yet been incorporated in analysts’ assumptions). Youtube has a strong moat in the US and Europe as user-generated and commercial content libraries are difficult to replicate and usage has continued to grow despite the existence of several competitor platforms.

Cloud is important to mention separately given the potential of this division to be another US$1T market for GOOGL. GOOGL’s current offering trails that of industry leaders Amazon and Microsoft, and requires significant capex to catch-up. In addition, Chinese competitors including Alibaba and Tencent are formidable challengers in this sector with the added advantage of China market access. Nevertheless, Google’s Cloud business has increased from US$4bn to US$8bn sales over Q4’17 to Q2’19. In my view, there are huge synergies between Cloud and GOOGL’s research projects into AI and network computing which are hard to value but represent upside.

GOOGL’s ‘Other’ businesses, whilst representing only c.15% of sales and majority loss-making, are the focus of GOOGL’s aggressive investment spend in recent years. Google’s Other Bets and Moonshot division, although not profitable, can be thought of as an option with huge upside, although the unknown probabilities of successes make valuation for this division very difficult. ‘Other Bets’ in artificial intelligence and driverless cars are also options with the potential to drive long term sales growth outperformance over the next decade. Moonshot (formerly ‘X’) is GOOGL’s highly secretive R&D business aimed at launching new disruptive technologies that have global impact over the long-term – there is no expected pay-off within the next 5 years. As projects reach the point of commercialization, they graduate from Moonshot and form independent businesses within Alphabet’s ‘Other Bets’ segment. Many will have enormous potential both as investments which could generate significant investor returns and as technologies that may one day dramatically improve our lives – however, valuation based on very limited information and wide variance of outcomes would be speculative. Therefore, I believe that these businesses, together with ‘Other Bets’, could be viewed as ‘call options’ with huge but unknown upsides (some analysts refer to this as an additional US$100bn equity upside opportunity). GOOGL’s track-record of businesses graduating from Moonshot provides comfort that the innovation pipeline works (e.g. Waymo, Google Glass, Brain, Chronicle, Loon etc.).

Investment thesis & value drivers

1) GOOGL can be considered a “Technology staple” plus option on potential upside from other businesses. GOOGL organic sales have consistently grown over the last ten years at an average of c.20-27%. Outperformance in the core business can be achieved through multiple levers, which provides the business with a quasi-staple and quasi-growth like profile. Ongoing monetization improvements in search and mobile, including AI driven updates and the creation of new ad channels, are the key drivers for the core business with several upsides not factored in (for example YouTube shopping integration an obvious read-across from the success of video shopping platforms in China). Outsized contribution from non-search businesses can also continue to drive upside with the most notable being significant value in computing power updates, Cloud / AI combinations. Other potentially huge value unknowns include partnership with China players in search technologies or cloud.

2) The advertising market opportunity is large (~US$1T), with global TAM split c.US$500bn brand marketing, $300bn direct marketing, $200bn trade promotion spend. Google only accounts for roughly 10% market share in this TAM providing significant white space to continue to further accelerate growth of Google’s Ad business – the most important cash flow segment. Secular growth for online advertising (US$200bn market growing at mid-teen percentages) is being driven by organic growth and ad spend shifting from offline to online. Incremental mobile usage presents an opportunity but also a threat.

3) Huge potential for Cloud. Q2’19 was the first time GOOGL provided public information on cloud sales (c.US$8bn). Whilst trailing domestic leaders (MSFT, AMAZ) and facing steep competition from Chinese challengers (Alibaba, Tencent, Sunning), Cloud has the potential to be another US$1T market for GOOGL. In addition, there is significant potential for value upside when considering the potential synergies across Cloud and GOOGL’s other competencies in AI, network computing and business applications.

4) Hardware represents another frontier for Google, with estimated hardware business potentially accounting for US$20bn sales and US$6bn of gross profit by 2021. Hardware sales also have significant synergy potential with Cloud, AI, network computing and business & gaming applications (e.g. Stadia GOOGL’s online gaming platform). Hardware also represents platform upside as Google’s Android OS can be further monetized through Google’s own app store and media center (Google Play).

5) Other Bets represent several ‘call options’ on game-changing upsides across multiple business with potential incremental value north of $100bn. ‘BERT’, GOOGL’s natural language processing software was described as the biggest leap forward in search over the past 5 years; Sycamore, GOOGL’s neural network processor recently completed a test computation in 200 seconds vs. years for the nearest supercomputers in existence. Waymo (autonomous driving) recently graduated from Moonshot and was given a paper valuation north of $100bn by analysts, however given uncertainty around commercialization the current GOOGL share price implies a significantly lower value (c.US$20bn). Another moonshot graduate, Verily, recently raised US$1bn financing from Silver Lake and OTPP in addition to US$800m from Temasek in an earlier round. Current GOOGL valuation does not reflect the full potential of this innovation pipeline given the uncertainty and wide range of outcomes for this collection of businesses. In addition, large cash burn in this division should be considered a drag on value. In our view the potential upside (some of which has been preliminary estimated by analysts but not reflected in the share price), outweighs the risk of over investment in low return projects.

6) Deep competitive moats around the business have developed through scale, aggressive product innovation, and very substantial investments in capex (US$69bn spent over last 5 years), and R&D (US$74bn over last 5 years) – this combination of moats would be difficult for a start-up to disrupt and has proven to be a strong defense against other deep pocket technology giants.

Valuation and innovation – valuing the unknown? – Current Price: $1,219.80. Target Price $1,400 plus option value (>8% upside to current)

GOOGL’s current valuation (15.1x EV/ 19E EBITDA; 25.1x P/E (FY19 EPS: $48.3) is just shy of fair value based on a conservative DCF approach. On a historical basis referencing the last three years, GOOGL is trading at the low-end of its EV / NTM EBITDA multiples and near its median on an NTM P/ E basis. GOOGL’s own trading history supports the current assessment of a ‘fair’ valuation with reference to its fundamentals. Based on a 5Y DCF the fair value is c.$1,315 per share (assuming 3.5% PGR, and 10% WACC), implying 16.5x EV / 19E EBITDA or 13.4x EV / 19E Adj. EBITDA (adj. for stock compensation), and c.27.1x P/E 19E (EPS $48.3). This represents 12.9x EV / 21E EBITDA or 10.4x EV / 21E Adj. EBITDA (adj. for stock compensation), and c.20.9x P/E 21E (EPS $62.6)

The ability of management to maintain strong organic sales growth at stable margins with controlled capex is the key value driver for GOOGL. Given the consistency of sales growth over the last ten years, I believe the management will continue to grow core ad sales and will supplement growth with monetization of YouTube and other properties. GOOGL’s ability to leverage synergies across its portfolio and new technologies will also help drive growth and margins outperforming single product peers. GOOGL maintains a strong and growing cash balance of c.$129bn including marketable securities (equivalent to c.15% of market cap.) with strong FCF generation in excess of US$20bn per year from 2020E (equivalent to c.3% market cap.). The FCF serves as value creation indicator for shareholders in light of nil dividends, although there should be a discount given the re-investment risk within GOOGL’s Moonshot businesses. In addition to FCF yield, GOOGL completed its largest share repurchase ever at $25bn (c.3% market cap.) in Q2’19, following $9.1bn (c.1% market cap.) repurchases in 2018 and the current repurchase in Q3’19 of $5.7bn (0.7% market cap.).

With reference to other technology peers (AMAZ, FB etc.) and the consumer staples sector (KO, MDLZ, PG etc.), GOOGL is trading at a multiple discount despite its superior growth profile. Peer comparison would suggest GOOGL’s fair multiple is closer to high-double digits 2021 EV/EBITDA vs. the low-double digit range it is currently trading at. The implied share price at 16.0x 21E EBITDA would be c.$1,600 (~30% upside). This potential value dislocation is interesting, however, to realize the ‘gap’ would require a fundamental shift in rating of the stock, which is unlikely to occur in the short-term, in particular with the current growth rate and capex spend. In the short-term an internet staple without dividends deserves a discount as control over cash use and burn is not with the shareholder, although this is mitigated slightly with the scale and consistency of recent share buybacks.

At this point, if we assume the core business is fairly valued with some upside from a long-term re-rating closer to the average consumer staple multiple, then we still need to value GOOGL’s ‘Other’ sales including ‘Other Bets’ and ‘Moonshot’ operations. I refer to this combined additional value as ‘option value’ above fair value. Other and Other Bets (combined c.15% of FY18A sales) is currently unprofitable, however assuming management can achieve GOOGL level profitability on this stream of revenues and applying a conservative 10x multiple would imply c.$250 of additional upside to the share price (c. 20% upside). The probability of this outcome is difficult to triangulate. GOOGL’s management team have shown strong discipline in monetizing businesses and unlike many listed technology stocks, GOOGL as a group has proven its ability to generate profits. The calculation here is intended to be a reasonable estimate of the scale of the upside. Another potential outcome is the spin-off and / or IPO of separate businesses within the portfolio, for example Weymo or Verily, taking advantage of the current start-up-listing friendly IPO market environment. A potential realization of Weymo’s estimated $100bn valuation would translate into c.$115 of additional upside to GOOGL’s stock price (c. 9% upside). Moonshot investments are near impossible to value. Some of the current Moonshot businesses have the potential to more than double GOOGL’s current valuation, however given how uncertain these outcomes could be, I have conservatively not accounted for these in the target price. However, given the significant levels of capex spent on these investments and management’s track-record in delivering value through innovation, investors should consider Moonshots as a valuable but unquantified option in GOOGL’s overall valuation.

Key risks

Search is a key component of the advertisement business, therefore any disruptive technology in this sector would significantly impact GOOGL’s ability to generate cash flows and support its other non-cash generative businesses. Mobile search is both an opportunity and a threat. If users’ uptake of super APPs overtakes or replaces general search websites, then GOOGL’s core properties may be bypassed. Data privacy issues are another key risk, where an unforeseen change in regulation or breach could negatively impact GOOGL’s model (similar to recent events at Facebook). Finally, excessive investment in Moonshots which do not materialize will be value destructive and impact shareholders’ view of management’s ability to maintain discipline with the company’s current large cash balance. GOOGL’s transformative innovation upside relies on heavy capex investment which would be restricted in this case.

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